May 2009

May 27, 2009

Andy Berg writes to tell me about a new IMF policy note on fiscal policy responses to the current crisis in Sub-Saharan Africa and the big news is that the IMF now thinks there is a role for increasing fiscal deficits even in some of the word's poorest countries. As Andy puts it,

About 2/3 of the countries in Sub-Saharan Africa now have low-to-moderate risk of debt distress, the way we calculate it. There may be some scope for some fiscal stimulus in many of these countries. Part of the case for not adjusting too sharply is that scaling down investment projects can be quite disruptive; to do it well puts a lot of demands on fiscal institutions. We note the contrast with "scaling up" of public investments, which is institutionally much more demanding.

In countries with fiscal space, the IMF recommends ramping up spending on Infrastructure and social safety nets (and not cuts in taxes, which the paper says would be inequitable).

The IMF hasn't totally given up on fiscal prudence of course. The paper warns that in resource-based economies, where the shock is concentrated in one or two sectors, the fiscal stimulus is unlikely to put capital and labor back to work since inter-sectoral mobility will be limited. It also asks that any fiscal stimulus be reversible to prevent debt problems down the line.

May 20, 2009

A long-standing debate between libertarians and others concerns the extent to which a state is needed to enforce cooperative rules. Many libertarians argue that informal, self-sustaining agreements can achieve desirable outcomes even without the state acting as a third-party enforcer. See here for a particularly interesting version of this argument and various counter-arguments.

Bo Rothstein's fascinating paper on efficient institutions concludes with a great story from the TV series "The Sopranos," which speaks directly to this issue and is worth quoting at length.

In a state of rage, the mob leader himself, Tony Soprano, with a gun in his hand goes after a low level gang member that has betrayed him and kills him. Usually, he would of course have used an underling for an operation like this, but this time ... he is so overtaken by emotions that he forgets the golden rule that mafia bosses should never do any of the dirty work themselves. As it happens, he is seen by an “ordinary citizen” chasing after the victim. This eyewitness goes to the police, not knowing that it is the local mafia leader that he has seen. The “ordinary Joe” tells the police that he is just sick and tired of all the violence in his neighbourhood and that he as a law-abiding citizen wants to help the police to clean up the neighbourhood. When the police commissars show him a bunch of photos of known criminals, he directly identifies the perpetrator - still not knowing who the person he identifies is. After he has left the police station, the police commissars are in a state of joy since they now seem to have what they need to put Tony Soprano behind bars.

In the next scene, the eye-witness is sitting comfortably in what seems to be a middle-class home listening to classical music. A woman his age, probably his wife, is sitting close to him reading the newspaper. Suddenly she starts screaming and then shouts at him to read an article in the paper. The article makes it clear to this honest and law-abiding citizen that the person he has identified at the police station as the perpetrator is the well-known local mafia leader Tony Soprano. The law-abiding citizen then throws himself at the phone, calls the police commissar who’s direct number he has, and in a terrified voice says that he did not see anything and that he will not become a witness.

The interesting thing is the book our law-abiding citizen was reading before his wife showed him the newspaper article. An observant spectator has about one second to see that it is the philosopher Robert Nozick’s modern classic Anarchy, State and Utopia - an icon for all ultraliberal, anti-government and free-market proponents ever since it was published (Nozick 1974).

The message from the people behind the Sopranos show seems clear: In a “stateless” Robert Nozick type of society, where everything should be arranged by individual, freely entered contracts, markets will deteriorate into organized crime. The conclusion is again, that there can be a market for anything as long as there is not a market for everything. Or in other words, if everything is for sale, markets will not come close to what should count as social efficiency.

Who knew that the writers of the show were academics manque?

By the way, Rothstein's Quality of Government Institute maintains an extensive data base on institutional indicators across countries and over time. It should be an important resource for people working on these topics.

UPDATE: Thank to Mike2 for posting a link to this YouTube video, which makes the point rather nicely.

May 19, 2009

There was a time when economists believed that institutional reform--improving governance--was a key ingredient in improving living standards in the developing world. "Good governance" is surely a good thing in its own right. But a lot of recent academic and policy research has focused of late on its instrumental value for growth.

The argument is simple and appealing. Rich countries are those characterized by democracy, rule of law, political competition, and low levels of corruption. So poor countries have to emulate them in all these respects if they want to get rich too.

Oddly, some of the most vociferous advocates of this view have apparently given up on it in the aftermath of the financial crisis. Not consciously, perhaps. But a repudiation is implicit in the arguments that they now make about the central role of governance failures in the current crisis in the U.S.

Exhibit no. 1 is Simon Johnson, who as part of the famous AJR (Acemoglu-Johnson-Robinson) triumvirate, has done as much as anyone to cement the view that better institutions cause higher incomes. In this view, the reason that the U.S. is richer than, say, Russia, is that the former is run by a democratic, accountable political authority that is not in the pockets of narrow interests. The AJR story presumes that institutional quality is a very slow-moving attribute, with events lodged deep in history still exerting strong effects today. Yet in his recent Atlantic piece, Johnson argues that U.S. economic policies have been captured by a (financial) oligarchy, in much the same way that business elites corrupt policy-making in much poorer countries such as Russia. The U.S., it turns out, is not that different.

Exhibit no.2 is Dani Kaufmann, who led the World Bank's work on governance and has done probably more than any other living soul to bring governance issues to the top of the policy agenda in the developing world. In a recent lecture, he takes pretty much the same line as Johnson, arguing that the financial crisis in the U.S. was the by-product of capture and corruption: "If anybody thought that the governance and corruption challenge was a monopoly of the developing world ... that notion has been disposed of completely." (I owe the reference to the Dani Kaufmann lecture to this very interesting paper by Bo Rothstein, a political scientist.)

Now I am a fan of Simon's and Dani's work, and I count them both among my friends. They may well be right about their diagnosis of the origins of the crisis. But an implication of their recent arguments is that we need to significantly downplay the role of improved governance as a causal mechanism for economic growth.

After all, no-one can deny that the United States, for all its financial follies, is a rich country. It turns out that it is possible to be corrupt in a fundamental way and still be rich.

My own view is that there was never a strong theoretical or empirical argument for relying on governance reform, as conventionally understood, as an engine of higher growth. The case for governance reform is that it is a good thing to do in and of itself. But don't confuse it for a growth strategy.

May 16, 2009

Three is a nice long article in the New York Times by David Leonhardt, in which we learn, among other things, that Tim Geithner is actually an old China hand. Which should come in handy as he tries to right the bilateral imbalance between the two countries that has clearly become unsustainable.

Most writing on this subject, the Leonhardt piece included, concludes that the Chinese end of the solution lies in stimulating consumption demand in China, and reducing that country's ridiculously high saving rate. But the discussion typically ignores an important issue: the secret of China's growth is that it has made a rapid transition into producing tradables (mainly manufactures). If the correction in China's trade balance comes at the expense of slowing down this process of structural change, it will also result in a reduction in the economy's longer-term growth rate. This would be a bad bargain for China, and it is an important reason why the Chinese authorities have resisted a significant appreciation of their currency (which, in the absence of other compensating policies, would have the effect of reducing the profitability of investment in tradables).

So if growth in China relies on continued structural change in the direction of tradables, but the international context no longer allows a large external surplus, must the world have to choose between global macro stability and Chinese growth? Is there any way out of the conundrum?

Actually, there is, but we need to think a bit out of the box. The economics of the situation is actually pretty simple. If China wants a larger supply of tradables than the market equilibrium produces, it can achieve this by directly subsidizing the domestic production of tradables (through tax incentives or rebates or reduction in the cost of inputs), while letting the real exchange rate appreciate to equilibrate the external balance. Direct subsidies don't tax the domestic consumption of tradables the way that currency undervaluation does. Presto! We have both the structural change China needs, and the external balance the world economy requires.

Put differently, if China gives up the exchange rate as an instrument of industrial policy, it will need a substitute. Explicit industrial policies are the obvious substitute. Across the board spending by China on infrastructure and other things doesn't quite achieve the required goal, unless the spending is targeted on projects that disproportionately reduce the costs of producing tradables.

There are of course small details to worry about, such as the WTO's Agreement on Subsidies. But we do need to think creatively about squaring the circle in question, and I cannot come up with any other alternative.

If you want to read more about this, here's a paper that explains the argument in greater detail.

Rightly or wrongly, some have interpreted Krugman’s recent Nobel address, which has gotten considerable play in Washington, as implying ambivalence about the benefits of trade for the U.S. What does trade theory tell us about the initiatives the US should make a priority in its trade policy agenda?

And my answer:

A society's gains from trade liberalization in different sectors depend on a lot of things, but as a rule of thumb, it is useful to focus on three things. (Here I will look at only U.S. policies, leaving aside the question of which initiatives should be pursued abroad.)

First, how large is the trade restriction (or subsidy) in question? Economic theory tells us that the gains from removing a tax or subsidy rise with the square of the wedge. So sectors where there are large policy interventions are particularly ripe for liberalization, everything else held constant.

Second, what is the likelihood that the liberalization will aggravate a pre-existing market imperfection? In the case of the U.S., the main imperfection I would worry about is technological externalities. These spillovers are likely to be associated with activities that employ lots of highly-skilled workers. My rule of thumb here would be that liberalization that results in the contraction of sectors that employ such workers is unlikely to generate much gains, and may even be harmful.

Third, is the liberalization likely to worsen income distribution at home? Many economists disregard distributional concerns (either because they do not think these are important, or else because they assume other policy instruments are available to deal with equity). But I do not find this a tenable position. So I would argue that any potential efficiency gains have to be traded off against potentially adverse movements in income distribution.

How do these considerations inform the question at hand, namely the nature of the initiatives the US should make a priority in its trade policy agenda?

Consider some obvious initiatives. On narrow economic efficiency grounds, the reform that would generate the biggest bang for the buck by far is the relaxation of visa restrictions that prevent unskilled workers from poor nations from being employed in the U.S. This is because the magnitude of the barrier in question here (measured by the wedge between earnings of otherwise similar low skill workers here and in poor countries) is bigger than in any other area of international commerce. But the trouble is that the likely distributional impact is also very adverse. So we can generate the efficiency gains only at the expense of making domestic unskilled workers worse off. Considerations 1 and 3 clash.

How about further trade liberalization in the conventional areas of manufactures? The problem here is that the barriers are already extremely low (in the low single digits), and the efficiency gains to be had are correspondingly small.

How about outsourcing? Outsourcing of low-skilled labor is on the whole bad for income distribution, while out-sourcing of high-skilled labor may run against consideration 2, the need to keep sectors that are the likely depositories of technological externalities at home.

So where does this leave us? I can think of two areas of liberalization where existing barriers are high and do not face the objections that I have considered so far.

First, agriculture. Subsidies and other trade-distorting measures are rampant in agriculture, especially in crops like cotton and sugar. It is hard to argue that these activities generate externalities or that their contraction would be bad for income distribution as a whole. So this is clearly an area of priority. (Note that I am not considering the impacts on other countries, which is not my focus here. The positive impacts abroad are typically vastly exaggerated, but the domestic benefits are not in question.)

Second, visa restrictions on highly-skilled foreign workers. The barriers here are large, since we know the visa quotas bind severely. Allowing more foreign scientists and engineers in will reduce incentives to outsource technologically-advanced operations abroad, and will help expand sectors that are likely to generate positive spillovers. The distributional effects are unlikely to be adverse, as it is the top of the labor market that will be affected.

So the trade policy initiatives that deserve priority in the U.S. are: liberalize agricultural trade, and expand visa quotas for highly skilled foreign workers.

Note that the U.S. can do both of these on its own, and does not need Doha or action on the part of the rest of the world to reap the gains from these reforms.

May 11, 2009

A lunch time talk by Niall Ferguson suggests a grim picture. Even if the world economy is not headed towards a 1930s-style catastrophe, it will remain mired in a "depression" like that experience in the 1870s, argues Ferguson, with long-term stagnation and deflation. This will be a bad time for everyone, except for populists and those who like to demonstrate in the streets.

The biggest winner? Ferguson suggests it may be China, who will supplant the U.S. as the global hegemon, as the U.S. replaced a similarly heavily-indebted Britain at the end of World War II.

I don't know about the China bit, but the rest is pretty scary. For a somewhat more cheery prognosis, you may want to turn to my latest Project Syndicate column, right here.

I agree with Niall Ferguson that the U.S. and the other advanced countries will not resume rapid growth anytime soon. With so many trillions of asset destruction, consumption growth will remain slow for a while, as will the process of finding another engine of growth to replace finance.

But as far as the developing nations are concerned, this need not be a tragedy. After all, their growth depends on their ability to import and deploy the stock of knowledge that already exists in the rich world--a stock that will not disappear or dissipate just because growth there has slowed down.

And as long as the de-globalization in question is simply a reversion to something like what we experienced in the 1960s and 1970s rather than the 1930s, the opportunities for convergence will still be there.

What will be ruled out of course is the kind of strategy that depends on external demand to increase the supply of domestic non-traditional tradables (manufactures, tradable services, and non-traditional agricultural products). This kind of undervaluation-cum-trade surplus strategy needs to be replaced by one that relies much more on domestic demand.

As I explain in my column, it is possible to spur the production of tradables without generating a trade surplus. The country that will need to undergo the largest adjustment of this type is China. And it is not clear that China is ready to undertake that transition.

May 04, 2009

Although we call the big three automobile companies they have basically specialized in building trucks. This left them utterly unable to respond when high gas prices shifted the market towards hybrids and more fuel efficient cars.

One reason is that Americans like to drive SUVs, minivans and small trucks when gasoline costs $1.50 to $2.00 a gallon. But another is that the profit margins have been much higher on trucks and vans because the US protects its domestic market with a twenty-five percent tariff. By contrast, the import tariff on regular automobiles is just 2.5 percent and US duties from tariffs on all imported goods are just one percent of the overall value of merchandise imports. Since many of the inputs used to assemble trucks are not subject to tariffs anywhere near 25 percent -- US tariffs on all goods average only 3.5 percent -- the effective protection and subsidy equivalent of this policy has been huge.

It is no wonder much of the initial foray by Japanese transplants to the US involved setting up trucks assembly plants, no wonder that Automakers only put three doors on SUVs so they can qualify as vans and no wonder that Detroit is so opposed to the US-Korea Free Trade Agreement that would eventually allow trucks built in Korea Duty-Free access to the US market.

What accounts for this distinctive treatment of trucks? An accident of history that shows how hard it is for the government to withdraw favors even when they have no sound policy justification.

It all comes down to the long forgotten chicken wars of the 60s. In 1962, when implementing the European Common Market, the Community denied access to US chicken producers. In response after being unable to resolve the issue diplomatically, the US responded with retaliatory tariffs that included a twenty five percent tariffs on trucks that was aimed at the German Volkswagen Combi-Bus that was enjoying brisk sales in the US.

Since the trade (GATT) rules required that retaliation be applied on a non-discriminatory basis, the tariffs were levied on all truck-type vehicles imported from all countries and have never been removed. Over time, the Germans stopped building these vehicles and today the tariffs are mainly paid on trucks coming from Asia. The tariffs have bred bad habits, steering Detroit away from building high-quality automobiles towards trucks and truck like cars that have suddenly fallen into disfavor.

If congress wants an explanation for why the big three have been so uncompetitive it should look first at the disguised largess it has been providing them with for years. It has taken a long time -- nearly 47 years -- but it seems that eventually the chickens have finally come home to roost.